Restraining Government in America and Around the World

Greetings from Austria

I spoke yesterday in Vienna on the third stop on the FMRS tour. My speech focused on solutions to the fiscal crisis. I pointed out the need to substantially reduce the burden of government spending and also warned against higher tax rates – in part because higher tax rates discourage much-needed economic growth.

This puts me in direct conflict with many European politicians, many of whom think extracting more money from taxpayers is the answer to the over-spending problem. Some of these politicians try to sound more rational by saying they don’t necessarily want to boost tax rates and instead would be happy to collect more money by more onerous enforcement of existing tax laws.

Macroeconomic and microeconomic modeling studies based on data for several countries suggest that the major driving forces behind the size and growth of the shadow economy are an increasing burden of tax and social security payments… The bigger the difference between the total cost of labor in the official economy and the after-tax earnings from work, the greater the incentive for employers and employees to avoid this difference and participate in the shadow economy. …Several studies have found strong evidence that the tax regime influences the shadow economy. …In Austria, the burden of direct taxes (including social security payments) has been the biggest influence on the growth of the shadow economy… Other studies show similar results for the Scandinavian countries, Germany, and the United States. In the United States, analysis shows that as the marginal federal personal income tax rate increases by one percentage point, other things being equal, the shadow economy grows by 1.4 percentage points. …A study of Quebec City in Canada shows that people are highly mobile between the official and the shadow economy, and that as net wages in the official economy go up, they work less in the shadow economy. This study also emphasizes that where people perceive the tax rate as too high, an increase in the (marginal) tax rate will lead to a decrease in tax revenue.

Interestingly, I just came across a new study from the Bank of Italy that looks at the issue from the perspective of “taxpayer morale.” The study finds that tax compliance also is sensitive to public perceptions about whether taxpayer money is being wasted. This excerpt touches on many of the key issues, and all I could think of when reading the study was bailouts, handouts, and other forms of corrupt and inefficient spending on both sides of the Atlantic:

…our measure of public spending inefficiency enters with the expected negative sign, and it is significant at the 1 percent level. Taxpayers interacting with a more efficient public sector are likely to show a higher level of tax morale. Our result can be interpreted by looking at the interaction between citizens and the government as a contractual relationship, implying duties and rights for each contract partner. If the taxpayer observes that the tax burden is not spent efficiently, he will feel cheated and his willingness to cooperate will fall. …Torgler and Werner (2005) state that greater fiscal autonomy allows regions to spend the tax revenues according to local preferences and this, in turn, might have a positive impact on tax morale. …As expected, the coefficient on the level of public spending per capita enters with a positive sign, and it is significantly different from zero. On the other side, we find a weak positive relationship between fiscal autonomy and tax morale, thus partially confirming the results by Torgler and Werner (2005). At the same time, the coefficient of public spending inefficiency remains negative and highly significant. …We find that tax morale is higher when the taxpayer perceives and observes that the government is efficient; that is, it provides a fair output with respect to the revenues. This evidence can be interpreted in terms of a psychological contract between taxpayer and fiscal authorities in which the former punishes the local government when he observes that resources are not spent well. Therefore, encouraging more efficient spending of public resources has wider consequences and contributes to increasing the citizens’ propensity to pay taxes.